Obama to California: Uh...

Yesterday, stocks lost 103 points on the Dow. This looked like a confirmation to us. The stock market appears to have begun its next and final phase...

AP seemed to think so too:

"Stock investors see threats from all directions," said the headline.

We didn't bother to read the article. We already know the directions.

From the north, investors worry about falling consumer demand. Consumers are in a funk - they have more debt, less income, fewer jobs, and less access to credit. The only news on that front we have today is that even jumbo housing loans are going bad...delinquencies are up to 9.6%.

From the east, investors worry about the continued invasion of cheap consumer goods and cheap services. China's economy is said to be growing at double-digit rates. How can US firms compete? And what if China is a bubble, as Jim Chanos believes? When it blows up, US stocks will come down too.

From the south comes the threat of higher interest rates. The poor dopes think the recovery might be for real. If so, inflation will rise and the feds will increase interest rates...possibly cutting off the new boom.

And from the west what do they have to fear? Well, there's that business in Europe. You know, Greece and all. The PIIGS - Portugal, Italy, Ireland, Greece and Spain... Europe's peripheral countries are in trouble. Lenders fret that they might be forced to default on their debt. So, they want higher interest rates. This, of course, just makes state finances worse...pushing the PIIGS closer to default.

The PIIGS owe $2 trillion, which might need to be restructured. Yes, dear reader, the sovereign debt problem is a big one - much bigger than Bear Stearns, Lehman Bros. and AIG. But the biggest porker of all - the USA - has fives times as much sovereign debt as all the PIIGS put together.

It won't take investors long to figure out that there isn't a whole lot of difference between Greece's finances and those of the US. Each has about the same amount of debt and the same size deficit, relative to GDP. The big difference is that the US ultimately controls the currency in which its debt is calibrated. Greece does not. Neither does California.

Both California and Greece borrow long-term at about the same rate...around 6%. Lenders know that when their backs are to the wall, both governments will have only two choices, not three. They can cut spending. Or, they can default. What they can't do is wiggle out of their obligations by inflating their currencies.

Jean Claude Trichet has already made that clear:

"...belonging to the euro area, you...have an easy means of financing your current account deficit. You share a currency that is credible, so that you have a quality of financing that corresponds to that of a credible currency."

He went on to say that Greece contributes only about 3% to the total output of the euro-zone. If push comes to shove, Greece will be pushed out rather than allowed to weaken the euro.

Then, Mr. Trichet made an odious comparison. California is a much bigger part of the US economy than Greece is of the euro economy. In fact, it is more than four times as large. Will the US come to California's aid? Mr. Trichet didn't say.

It is possible, of course, that Mr. Obama will say to the Golden State what Gerald Ford said to the Big Apple. In 1975, New York City's back was to the wall. It appealed to Washington for help. "Ford to City: Drop Dead," was the famous headline in the New York Daily News, reporting the president's response.

New Yorkers were incensed. Later, they realized that by vowing to veto a bailout President Ford had done them a great favor; he forced New York to clean up its act. The city went on to its greatest years. Likewise, the feds would be doing all of us a favor by letting failure fail with dignity.

Will Obama help California mend its ways? Or will he turn it into a zombie state?

Bill Bonner
for The Daily Reckoning Australia

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First came Enron, with $65.5 billion in assets, going belly-up and becoming the largest bankruptcy in US history at that time. The stock went from a high of $84.63 in December 2000 to a whopping 26¢ one year later. And what had we been told by the media? Fortune magazine dubbed Enron "America's Most Innovative Company" for six consecutive years.

Next came WorldCom filing for bankruptcy in 2002, their assets of $103.9 billion dwarfing Enron's. Tyco, Adelphia, Peregrine Systems...also made headlines for their acts of fraud and mismanagement.

A few years later, Bear Stearns set us all up for the Big Meltdown of 2008. It was B.S. (no, I mean Bear Stearns) that pioneered the asset- backed securities markets, and we all know how that turned out. Later we learned that as losses mounted in 2006 and 2007, the company was actually adding to its exposure of mortgage-backed assets. With net equity of $11.1 billion supporting $395 billion in assets, Bear leveraged itself up to an astonishing 35-to-1.

And during it all, Bear Stearns was recognized as the "Most Admired" securities firm in a survey by Fortune magazine (there's that Lower Manhattan tabloid darling again). Frequent sightings of company executives on country club fairways assured the public that all was well. And CEO Alan Schwartz told us there was "no liquidity crisis for the firm" and insisted he "had the numbers to back it up." His company was sold four days later to JPMorgan Chase at $10 per share, a 92% loss from its $133.20 high.

Lehman Brothers, the 158-year-old investment bank, was next and still today holds the title as the largest bankruptcy in US history. L.B. succumbed to 2007's Word of the Year, "subprime," and its $600 billion in assets all went poof! In just the first half of 2008, before the meltdown, Lehman's stock slid 73%.

And what did CEO Dick Fuld tell us in April of that year? "I will hurt the shorts, and that is my goal." He must have been referring to the attire of his tennis club buddies, because the ones who actually got hurt were numerous other banks, money market funds, institutions, hedge funds, REITs, brokers, private and public trusts, foundations, government agencies, foreign governments, employees, and investors.

Moving on to the largest US government bailout recipient by far, AIG's troubles spawned my favorite placard of the decade: seen outside their Manhattan offices stood a sign that simply read, "Jump!" Maybe its creator heard what I did from AIG's financial products head Joseph Cassano: "It is hard for us, without being flippant, to even see a scenario within any kind of realm of reason that would see us losing one dollar in any of these [credit default swap] transactions."

Oops!

Topping off our list of the infamous debacles of the decade is Bernie Made-off (er, Madoff), who scammed $65 billion over 20 years from unsuspecting institutions and wealthy investors...

By now you are probably wondering... What's bigger than all these debacles? He's covered the major frauds and scams of the past decade - what could possibly be left?

To quote my favorite sleuth, Hercule Poirot, "When all the facts are laid before me, the solution becomes inevitable."

Here are a few clues...

Federal Reserve Chairman Ben Bernanke said on July 16, 2008, that Fannie Mae and Freddie Mac are "adequately capitalized" and "in no danger of failing." Then-Secretary Treasurer Henry Paulson declared on August 10, 2008, "We have no plans to insert money into either of those two institutions."

- Both Fannie and Freddie were nationalized 28 days later, on September 8, 2008.

Ben Bernanke claimed on February 28, 2008, "Among the largest banks, the capital ratios remain good and I don't expect any serious problems of that sort among the large, internationally active banks..." Henry Paulson added on July 20, 2008, that "It's a safe banking system, a sound banking system. Our regulators are on top of it. This is a very manageable situation."

- Since the recession started in December, 2008, 144 banks have failed.

Paulson informed us on April 20, 2007, that "All the signs I look at show the housing market is at or near the bottom."

- The number of foreclosures skyrocketed shortly thereafter and will now any day surpass those during the Great Depression.

Ben Bernanke announced on June 20, 2007, that "[The sub prime fallout] will not affect the economy overall."

- Less than one year later, the stock market crashed, losing 53% of its value, and is still down 25% despite one of the biggest bounces in history.

Those in charge of our country's finances not only failed to see the crises developing and then bungled the handling of the recovery, they've deliberately misled us about what they're doing to our currency. In spite of emphatic promises, flowery speeches, pat-on-the- back assurances, and continual reassurances, here's what they've actually done to the dollar:

• Since September 1, 2008, the monetary base has ballooned from $908 billion to $2.0 trillion. The current monetary base is now equal to bailing out General Motors 23 times.
• Bailout funds in 2008 and 2009 total $8.1 trillion. That's almost 78 WorldComs. It's over 123 Enrons.
• US debt has risen sharply, from $6.2 trillion in 2002 to $12.1 trillion today. That's over $39,000 per citizen.
• David Walker, the comptroller general of the Government Accountability Office from 1998-2008, warned that the US is on the hook for $60 trillion in unfunded liabilities. Independent analysts peg the figure at near twice that. Whatever the number, it is incomprehensibly large. The only way we will meet these liabilities is to print the money and inflate them away.

We're bailing out corporations that should fail, making financial promises we can't keep, and adding layers of debt we can't possibly repay. And the real killer is, if we don't have the cash, we just print it. It is, by any reasonable account, the "blunder that will plunder" the next several generations. It is changing America permanently, and the problems will persist long after you and I are laid to rest.

Bottom line: after all the bailout programs, housing initiatives, rescue efforts, stimulus schemes, bank takeovers, wars, unemployment benefit extensions, and numerous other promises, the biggest financial deception of the decade is what the US government is doing to the dollar. Nothing else even comes close.

This reckless activity has spooked our foreign creditors, weakened our global standing, diluted our currency, is punishing savers and retirees, and ultimately sets us up for a level of inflation this country has never seen before.

Yet, what is the guardian of our economy and money telling us now?

"Will the Federal Reserve's actions to combat the crisis lead to higher inflation down the road? The answer is no; the Federal Reserve is committed to keeping inflation low and will be able to do so. In the near term, elevated unemployment and stable inflation expectations should keep inflation subdued, and indeed, inflation could move lower from here." (Ben Bernanke, December 7, 2009).

This is pure rubbish. If inflation could be controlled by just thinking stable inflation thoughts, then Ben should be able to grow a full head of hair by just thinking scalp follicle thoughts. This is so ridiculous, it's insulting.

Government actions make a mockery of their words; what they say and what they do are diametrically opposed. It's clear that inflation is not a question of "if," but "when."

Any level-headed individual has to conclude that there will be a steady - and likely accelerating - decline in the dollar's purchasing power. It's inevitable.

The great masses don't quite understand it yet, but they will. There will be no escape from the cold, hard slap in the face citizens will receive when a high level of inflation arrives. And when it does, it will make a mockery of any opposing viewpoint.

So the question before you is simple: Will you be a prepared survivor for what lies ahead, despite what our government leaders tell us, or will you be a complacent victim of the biggest financial deception of the decade?

For me, there's only one solution. Don't kid yourself into thinking a man-made asset will protect your purchasing power. This is the time to be overweight gold and silver. I advise letting them serve their purpose for you.

Regards,

Jeff Clark
for The Daily Reckoning Australia

• Investors Better Off Investing in Anything but Stocks
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• U.S. Stocks Hammered to Dust

The first is that Abu Dhabi extended a $10 billion in financing to debt-distressed Dubai. Hossanah! Remember, Dubai is not Lehman. It's Bear Stearns. It's merely the reminder that there are lot of leveraged investors in the world who've used borrowed money to buy assets that aren't very productive. They'll get theirs soon enough.

The second bullish item is that ExxonMobil (NYSE:XOM) made a US$41 billion all stock bid for Houston-based natural gas company XTO. This sent Exxon shares down 4.4%. Thus the Dow's rally was a bit tepid (XOM is a Dow component).

By the way, we've probably mentioned it before, but it's normal for the shares of the acquiring company to fall on an acquisition announcement. The shares of the company being acquired, obviously, usually rise to near the price per share indicated by the value of the bid. You can engage in this kind of arbitrage trading...if all you do is sit around at a desk all day and figure out who's going to be acquired and who's going to do the acquiring.

Exxon is either getting a bigger foot in the U.S. natural gas market or hedging against cap-and-trade legislation, or both. We vote for both. No one is in a better position to know about the constraints on global oil production and discovery of new reserves than a major company like Exxon. And Exxon has seen firsthand that unconventional natural gas can be a lucrative little market.

But are those two bits of news really enough to send the market higher? Probably not. Who knows why the market goes higher? It does what it does. There's an alternative explanation.

The alternative explanation is that the Copenhagen climate talks look like they're collapsing into confusion and President Obama's legislative agenda is in tatters. The private sector absolutely loves this.

Mind you we're not addressing any public policy issues here. We're not that smart. But politics has an effect on markets and lately one of those effects has been a huge increase in uncertainty...uncertainty about the cost of carbon dioxide emissions...the cost of health insurance...the size of government deficits...and more regulation in all aspects of corporate and private life.

Good policy? Bad policy? Who knows? All we know is that the more uncertainty you introduce into the markets, the more conservative and defensive investors are going to get. It's hard (and unwise) to make long-term plans when short-term laws and regulations are always changing. No wonder bond yields are so low. A near-nothing return on cash is still much safer than taking your chances in the equity market.

That's not to say that a deal won't come out of Copenhagen. Maybe the planet will be saved. Or maybe Copenhagen is the sell signal for global warming as a big idea/moral issue with which to bash the public. But either way, we reckon the stock market actually likes the idea that no climate deal is imminent and that healthcare legislation in the U.S. Senate can't seem to get 60 votes.

Dan Denning
for The Daily Reckoning Australia

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But first things first. Dubai World is not nearly large, leveraged, or systemically important as either Bear Stearns or Lehman Brothers when both those firms failed. For those reasons, it's unlikely that the failure of Dubai World (and we're not saying it will fail) would, by itself, cause a global deleveraging.

Dubai World has $59 billion in debt. That makes up the majority of the $80 billion in debt of Dubai itself. According to Reuters, international banks are exposed to $12 billion in debt. Incidentally, the Commonwealth Bank of Australia said it has exposure to Dubai but doesn't expect to make a loss.

There is some risk to CBA, no doubt, just as there is risk Dubai's other lenders. But it's nothing like the risk posed to the entire financial industry by Bear Stearns and Lehman Brothers. For starters, the Bear Stearns High-Grade Structured Credit, and High-Grade Structured Credit Strategies Enhanced Leverage Fund were both massively leveraged. The first fund began with $600 million in assets but quickly borrowed on that to increase its asset portfolio to over $6 billion.

The trouble with that is Bear geared up to buy collateralised debt obligations (CDOs). It may not have known it at the time, but the CDO quality sucked. The CDOs were chock-full of subprime mortgages. In 2006 alone, $503 billion worth of CDOs were issued. It was a $2 trillion market by 2008. A fall in the value of Bear's assets - a big chunk of which were CDOs - was enough to wipe it out.

Dubai World is likely to be backstopped - at some point - by Abu Dhabi. And although we're sure it has its fair sure of property assets falling in value, Dubai World owns assets all over the world which it can sell. And, importantly, Dubai world is probably not a counterparty to many other financial arrangements in the same way Lehman Brothers was, at least as far as we know.

But still. You wouldn't be alone if you had an odd sense of déjà vu this morning. We'd say the Dubai affair is more like Bear and less like Lehman because it's a warning. Dubai may not be as systemically important as Lehman, but it is a reminder to all the world's investors that global financial markets remain highly leveraged. And we know what can happen next.

There are other, much bigger, and much more leveraged markets that pose far bigger risks to the global economy. For example, in the U.S., there is over $3.4 trillion in debt backed by commercial real estate owned by U.S. banks. A presentation by a Federal Reserve analyst in late September suggests that the U.S. banks have failed to set aside adequate capital to cover losses in commercial real estate. It's safe to say the U.S. banking system - and by extension Australia's - would not survive another real estate collapse without major casualties.

And that is just one debt bubble. The other large debt bubbles are in China - which hedge fund manager Jim Chanos calls "Dubai times 1,000" and in government debt. The China bubble and the U.S. Treasury bond bubble ARE systemically important. And that's what we should be worried about now.

But what's happening in the short-term is not quite what you'd expect. Emerging market stocks are selling off. In fact, don't be surprised if Dubai is just the excuse fund managers use to take profits on a lot of 2009 positions. It will make this year's performance statistics look great by crystallising a profit now. And who can blame a manager for being cautious?

Already the cost of insuring sovereign debt from default - as measured by credit default swap rates - is rising. Yes, it does seem a bit absurd that debt crisis in emerging markets is driving investors into U.S. Treasury debt. But that's what's happening in the short-term. You may get a dollar rally and lower short-term U.S.rates.

How will Australian share markets fair, then? Good question...

It depends on how the rest of the world views Australia. If it's viewed as essentially an emerging-market, commodity-related, high-yield risk asset play, stocks are going to get sold off. The Aussie dollar will give some ground against the greenback. And the market will wait to see how exposed Aussie banks are to any of the bourgeoning debt bubbles.

The bigger issue is the exposure of the Australian economy to the Chinese economy. According to the government and the media, that is the difference maker for the Aussie economy. It's what guarantees future surpluses, growth, and prosperity. But if the Aussie economy is hitched to China on the upside, surely it's hitched to China on the downside too.

Not that any of this potentially catastrophic news should stop Aussie houses from getting bigger or more expensive!

CommSec released a report yesterday showing Aussie houses are now the biggest in the world. The floor area of the average Aussie home is now 215 square metres. That's a ten percent increase in the last ten years. Maybe Australians just need more living room!

The world's growth is built on a debt bubble. The bubble is popping. Dubai is a tiny bubble by comparison. The bigger pops are coming.

Here's a question. What if there was a serious debate about the integrity and objectivity of scientists who are pushing climate change, and the Australian media decided to bury the story? You would hardly know a big debate is raging about how honest the scientific establishment has been with its...er...science in support of anthropogenic global warming.

If you're just catching up to the story, try this.

In the meantime, we returned from New Zealand to find the political establishment in an uproar. The Labor party and the media are having a field day at the disarray in the Liberal party over its climate change policy. It's all quite entertaining.

But it's also all quite a huge charade. How can you have a serious debate about an emissions trading scheme and carbon dioxide emissions in Australia without acknowledging the fact that a major global debate is now swirling about the science itself. Does it make any sense at all to make policy when the problem itself is in dispute?

Dan Denning
for The Daily Reckoning Australia

• Dubai, Built on Debt and Sand
• The Trouble With a Sovereign Debt Crisis
• Copenhagen Climate Talks Possibly Sent the Market Higher
• Arab Wealth Pours Back into Dubai
• Lehman Brothers (NYSE: LEH) Is Not Dead Yet

One of the most interesting news items I've found was on the cover of The Financial Times, where I learned that a guy named Lahde "made tens of millions of dollars from betting against the financial and property sectors during [the] past two years", and he now wanted to thank "the low hanging fruit, i.e. idiots whose parents paid for prep school, Yale, and then the Harvard MBA" who made it all possible for him to find enough suckers.

He noted that "These people who were often truly not worthy of the education they received (or supposedly received) rose to the top of companies such as AIG, Bear Stearns and Lehman Brothers and all levels of our government. All of this behavior supporting the aristocracy," he says, "only ended up making it easier for me to find people stupid enough to take the other side of my trades. God bless America."

This goes along with an article in the St. Petersburg Times about Tom James, chairman and chief executive of Raymond, James Financial, who had "some tough words for the wizards of Washington, DC who oversaw the $700-billion bailout package".

He reports, "The Brave And Wonderful Mogambo (BAWM) was right all along! Those government weenies are the biggest freaking morons you ever saw, and we as a country should be ashamed of ourselves for having elected such corrupt, half-witted, utter failures and congenital idiots!"

As you have probably guessed by now, he did not say those exact words, but he implied every syllable when he said, "Legislators were almost embarrassingly ignorant of how the financial system works", which I figure explains how they don't understand the linkage between their own Bad, Bad Performance (BBP) as legislators and the subsequent Bad, Bad Performance (BBP) of the economy, and he says that only 3 of 16 legislators that he talked to actually understood what was going on in the "credit crisis." Less than 20%! Hahaha! We're doomed!

Well, maybe these Congressional losers will understand the unfolding economic slowdown, as evidenced by the Baltic Dry Index, which is an index of the cost to transport stuff by cargo ship, and which has fallen precipitously, which seems very important to me, and to Junior Mogambo Ranger (JMR) Riccardo, too, who is also alarmed by this like - as I previously said - me.

It's actually beyond scary, in a terrifying kind of "ain't nobody buying nothing in a consumer economy" kind of way, which means that without the consumer buying stuff as his or her contribution to the famous statistic of "the consumer is 70% of the economy", we are, in case you ain't heard, freaking doomed!

Well, maybe not all buying is drying up, as silver market analyst, Ted Butler, reports that in the last 10 months, "some 150 million ounces of silver can easily be documented to have been bought by investors. Undocumented purchases would add tens of millions more ounces."

In fact, when you add it all up, "Investment demand for silver this year is running at a full 25% of world mine production and over 20% of total production (including recycling). This is a remarkable historical turnabout."

Thus, it is easy to see why Mr. Butler is "bullish beyond belief for silver", since this kind of demand means that "In silver, the documented 150 million ounces bought in the first ten months of this year is equal to 15% of all the silver bullion equivalent thought to exist!" Wow!

More than one-seventh of all the silver bullion "thought to exist" in the whole world was suddenly bought up in less than a year, and yet the price of silver has been pounded down to less than 10 bucks an ounce? No wonder I am so bullish on silver!

He also notes that the gold/silver ratio is at more than 80, which is "one of the biggest differences in history."

And not only that, but since there are 4 to 5 billion ounces of gold in the world versus only 1 billion ounces of silver, that means that "the total dollar value of all the gold in the world is worth 300 to 400 times more than all the silver in the world (80 times 4 or 5)".

Talk about undervalued! Hey! This investing stuff is easy! Whee!

Until next time,

The Mogambo Guru
for The Daily Reckoning Australia

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Since productivity growth is used to estimate unit labor cost growth, costs also must be understated for the service sector as well, which further implies service sector profits are overstated. This should all come out in the wash in future revisions, but for the meantime, it is very likely that the GDP, consumer spending and profit realities are worse than currently reported.

Transfer payments have reached a higher share of personal income than interest and dividend income. Together, that means over 30% of the U.S. personal income flows are now being earned for no increase in work devoted to production of goods and services (although we do recognize loans earning interest may, in fact, finance increased production, rather than financial market speculation). The more people get paid without directly producing goods and services, the higher the inflationary bias likely to arise in an economy. Purchasing power without production is another, perhaps more accurate, way of depicting the old saw about "too much money chasing too few goods."

Money doesn't chase anything. People spending money who did not produce anything to get the money - now, that's a recipe for inflation (or less disinflation/less deflation, than otherwise would be the case from favorable cost and supply conditions, to put the point more generally). In this regard, the major rise in transfer payments from 1966-76 may have played a role in the original onset of the stagflationary '70s, while the surge in interest income from 1978-82 may have contributed to the second wave of stagflation. Higher money incomes without increased production tends to lead to higher prices, unless, of course, saving rates among money income recipients rise sufficiently. Treasury Inflation-Protected Securities have been one way to hedge for an eventual inflation result, although they are no longer as cheap - but then again, neither are most inflation hedges, which have, for the most, part been bid up year to date.

We have been investigating which sectors have been accumulating Treasuries lately, as we believe placing new Treasury bond issuance may become more challenging not just because of the huge supply forthcoming, but because the quantitative easing measures adopted by the Fed and other central banks are designed in part to force investors out of the risk spectrum and away from cash and default-free Treasury holdings. Results from the Fed show broker-dealers, foreign investors and money market mutual funds have been the largest buyers of Treasuries of late. We are especially concerned the large buildup of long Treasury positions at primary dealers is unlikely to be sustained and there may be a rout in the Treasury market reminiscent of 1994, when Goldman Sachs had to borrow from the Japanese in order to stay afloat after getting caught the wrong way round in yield curve carry trades.

With 10-year Treasuries hitting 3.36% and passing through their 200-day moving average this week, our concern is looking less and less theoretical. We asked seasoned bond veteran Lou Crandall at Wrightson Associates about the unusual buildup in dealer position in Treasuries, and this was his assessment, which we have corroborated elsewhere:

"The large structural short positions that dealers developed in the middle part of this decade were a function of their market-making and hedging strategies. As a general matter, dealers would hold inventories of less-liquid spread products such as mortgages, ABSs and corporates on the long side, and then hedge them by shorting Treasuries of comparable duration.

"Once the liquidity crisis hit in the summer of 2007, a couple of things happened. First, the basis risk on those trades exploded, because spreads became highly volatile. Treasuries were no longer as efficient a hedge for private instruments as they had been. After Bear Stearns, you also started to see a rapid contraction in dealer balance sheets - even if Treasuries had still been an effective hedge for private-sector instruments, dealers were trying to lighten their inventories of those private obligations.

"In 2009, a couple of additional factors have come into play. Dealers wanted to front-run the Fed's purchases of Treasuries, which probably led to a modest amount of speculative long positions in Treasuries. More importantly, the Treasury market in May has adopted new delivery protocols that impose a 300-basis point penalty on anyone who fails to delivery a Treasury on time. The prospect of that fee created a lot of uncertainty in the market in April, and led some dealers to conclude that it would be safer to conduct their market-making activity from the long side, rather than the short side, of the market in the near term. (Just about everyone came to that conclusion about the bill sector, but some applied the same logic to coupons.)

"The increase in outright long dealer positions in Treasuries is close to having run its course. We could continue to see increases for a few more weeks as dealers complete the transition. However, we are seeing a restructuring of dealers' market-making business model, rather than an increase in outright long-term holdings in Treasuries driven by an investment view on the part of the dealers."

Essentially, dealers covered their spread trades by purchasing Treasuries and selling agency mortgage-backed securities and corporate bond positions. Some of them reconfigured themselves as banks, where procedures for the risk weighting of capital favors holding Treasuries. These, along with some procedural changes, are essentially one-off transitions. We, therefore, do not believe broker-dealers are likely to be big buyers in future Treasury auctions. Unless U.S. macro data start to get more alarming soon - and auto production cuts could dampen the Institute for Supply Managements' numbers, while the minor consumer bounce in Q1 was really mostly over in January and could cool further in Q2 - Treasury yields are likely to surge higher. So far, the backup in Treasury yields has not taken 30-year fixed mortgage rates higher, but this is the type of challenging set-up in the Treasury market that could squash attempts to stabilize the U.S. housing market. If you were planning on refinancing your mortgage this year, you may wish to consider acting sooner rather than later.

Best regards,

Rob Parenteau
for The Daily Reckoning Australia

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Isn't it ironic how creatively regulators were interpreting Reg FD laws with all of this week's leaks to the press? The leaks may not be very relevant, but they are yet another sign that this stress test was designed for public consumption. It was intended to bolster public confidence in the banking system, and I'm shocked at the lack of skepticism among the professional investment community.

Once it was announced that bank executives were pushing back on regulators about their forecasted losses, the stress tests instantly lost a great deal of their credibility. What kind of test in school allowed you to argue with your teacher about the correct answer?

Just like a student either knows their subject or does not, a bank's capital will be sufficient to weather this crisis without obscene levels of government subsidies, or it will not. If it is not, the FDIC should resolve it at a measured pace to minimize taxpayer losses. With Bear Stearns more than a year in the rearview mirror, there's no excuse for top regulators to not have a mechanism for unwinding complex bank/brokerage institutions - in which losses would be borne by shareholders and bond holders - rather than taxpayers. Instead, the authorities are trashing the value of the U.S. dollar and blowing up the deficit to potentially unmanageable levels.

Independent regulators - not bank executives - should be the sole judges of capital adequacy under a stress scenario. We all know what kind of biases bank executives tend to hold about their own loan books.

We have probably not seen the end of the stress test process. If the future data flow on loan delinquencies comes in higher than the current "stress" scenario, then we may see a scenario where a major bank (or three) gets massively diluted. For a model of what night happen to shareholders at the most toxic of the megabanks, consider the proposed exchange offer for GM bondholders, which would leave current GM shareholders with a 1% equity stake in the "new" GM. Why any professional can justify investing client capital in such megabank stocks is beyond my understanding.

The market's reaction to the stress test - in the form of soaring bank stocks - tells me that the consensus is treating this stress test as if it has the ability to magically predict yearend 2010 capital levels with pinpoint accuracy.

Most of us do not have magic predictive powers - only the ability to make judgments based on knowledge and experience. In my judgment, the stress test was not stressful enough. For instance, it is not really accounting for borrower behavior in a scenario where they are underwater on their mortgage and under- or unemployed.

The stress test's estimated losses on second-lien mortgages in particular seem very low. In foreclosure, these are often total losses. With another big wave of Alt-A resets and foreclosures in the pipeline, the performance data on second lien mortgages should worsen. Several state-imposed and bank-imposed foreclosure moratoriums are ending.

The bulk of housing activity right now consists in foreclosure auctions and short sales. How much are second mortgage liens worth under this scenario? Not much.

Most big banks already have low levels of tangible capital relative to towering trillions in risky assets. The cash flow from their existing and new loans must exceed their loan losses in order to simply maintain existing capital levels (let alone increase capital). Here's the illustration I used in the March 27 Strategic Short Report alert:

"Think of this situation as a bathtub. Bank capital is the amount of water in the bathtub, and the faucet pours new water into it (that's cash flow from existing, paying loans and securities, plus new capital infusions) and the drain sucks it out (these are the loan losses). Pessimists claim that the drain of losses is sucking water out so fast that it will empty the bathtub within a year or two, depending on the bank. They tend to ignore or downplay the new water coming in. Optimists claim that if regulators allow the water level to fall to a very low level during this crisis (regulatory forbearance), in time, the water level will eventually rise back to normal levels. There's a risk that if the optimists are wrong about the amount of new water coming in, we'll be stuck with a Japanese-style "zombie bank" situation.

After this week, I think the risk of the zombie bank scenario is much higher. We'll probably see this manifested in continued tight credit conditions. The banks under the most intense scrutiny will tend to reinvest cash flows into less risky assets like Treasuries and agency mortgage-back securities (another form of government guaranteed debt) - rather than write new commercial or consumer loans.

Regards,

Dan Amoss
for The Daily Reckoning Australia

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It's not just that stocks are falling, although they did that yesterday in both Sydney and New York. It's that in the rush to the fill void of bankers who've currently gone on strike, more and more tax and pension money is being put at risk in markets. At this rate, if you're serious about your retirement plans, you'd better have a close look at what your government is doing to your money and your pension/retirement assets.

But let's go back to the beginning, with bankers going Galt. Going Galt, of course, refers to the strike of the wealth producers in Ayn Rand's book Atlas Shrugged. High taxation, wealth confiscation, and wealth redistribution drive a whole class of hero industrialists to take a runner on capitalism and retreat to a secret fictional valley in Colorado called Galt's Gulch, where they catch and grill trout and wait for the world to burn down.

The comparison breaks down now that we think about it. A small portion of today's bankers are not wealth producers. They are wealth stealers (or destroyers). But let's run with the idea that they are going on strike. What do we mean and what does the idea mean for Aussie mining companies?

By bankers going on strike, we mean that local Aussie banks are not doing much to help local Aussie miners raise money to stay in business. While the government has set up Rudd bank to fund "viable" commercial property developments (which indirectly supports bank loan portfolios), it apparently thinks the best thing to do for the miners is let them go broke (as they do at this stage of the resource cycle) or sell them to China. It is clearly of two minds on this last option (or of no mind at all, perhaps).

Why aren't the banks lending locally and what are they doing instead? Well, they're probably terrified that commodity prices won't recover any time soon, rendering the collateral posted by mining companies worth a lot less. Or, worried about future losses in commercial property, the banks are saving up for a rainy day.

In fact, one place they are saving is at the Reserve Bank of Australia. That's where banks can park money in RBA's exchange settlement accounts. Late last year, the banks were parking billions of dollars there overnight. For three days in October, the total figure crested over $10 billion and on December 19th, it spiked to over $16 billion. Using our crude Excel skills, we've built a chart of your showing the overnight balances in ESAs since the credit crisis broke in June of 2007, when two hedge funds owned by Bear Stearns went bust.

Source: Reserve Bank of Australia

The RBA pays an overnight interest rate on ESA balances that's 25 basis points below whatever the current cash rate is. It does this to encourage banks to lend money into the marketplace and not hoard it at the RBA. Or in the Bank's own words, "the rate on ES balances is set 25 basis points below the cash rate target to encourage ES account holders to lend surplus funds into the market rather than leave them with the RBA."

But here we are over eighteen months into the great global deleveraging and Aussie mining firms can't seem to borrow money from Aussie banks. "Mining companies will be forced to consolidate and seek further support from Chinese and other Asian state-owned interests as local and foreign banks baulk at committing to $36 billion in loans due from the sector in the next two years," report Jo Clarke and Katja Buhrer in today's Financial Review.

"The collapse in commodity prices has threatened the viability of new projects and slashed mining profits, pushing more producers down the path taken by Rio Tinto (ASX:RIO) and Fortescue Metals Group (ASX:FMG), which have sought large capital injections from Chinese state-owned enterprises." And Lachlan Edwards, head of corporate financing at Goldman Sachs, adds that, "The majority of mining companies in Australia are going to be dependent on fighting for limited bank availability,".

If you grant that a large portion of the debt that comes down is Rio Tinto's US$18.9 billion to pay for the Alcan acquisition, you still have a lot of company's left on the outside looking in. They really have only four options: tap private bond markets as BHP has in the last two weeks (although smaller firms won't be able to do this), rights issues to raise money from existing shareholders (hello Rio), asset sales, or...find a capital partner in China.

"But wait," says Australian Small Cap Investigator guru Kris Sayce. What about the $50 billion Future Fund? Does it have a role to play in capitalising Australia's credit-starved small cap miners?

"We're not sure what's going to happen to the Future Fund, but its chairman David Murray has put himself about recently." Kris writes in today's Money Morning (his daily e-letter on Aussie share markets) "We wonder if this is the first step in the transformation of the Future Fund."

"If you recall, the Fund was set up to cover the underfunded public defined benefit pension fund. The main sources of the funding were from government profits (i.e. It taxed more than it spent) and the transfer of the last batch of Telstra shares....So why the sudden increase in David Murray's profile? He's been pouring forth on the global economy, on the Australian banking system, and now according to The Age newspaper, credit ratings agencies."

"Our guess is that with billions of dollars under management, and the clamour for more stimulus packages, the temptation for the government to dip into the Future Fund and spend it 'in the national interest' will be too much to resist."

Hmm. Interesting. China Inc. has much deeper pockets than the Future Fund. But if Aussie banks and foreign banks won't extend new lines of credit to miners like OZ Minerals, maybe the Future Fund will. Stay tuned.

Also be warned. Investing the assets of public pensioners in the stock market doesn't always work out. Remember, the stock market is not a retirement machine. It involves risk. Just ask the Pension Benefit Guaranty Corporation (PBGC).

The PBGC is the agency set up by the U.S. government to cover the defined benefit pensions of employees of bankrupt companies. When companies aren't going bankrupt, it's not necessary for the PBGC to funded by Congress. The company can manage its own assets.

But lately, the PBGC has been pretty busy. And with Chairman Obama indicating that General Motors is headed for bankruptcy, the PBGC will have even more defined benefit pensions to pay out in the coming years. Too bad it dumped most of its assets into the stock market in the last few years.

The Boston Globe reports that, "Just months before the start of last year's stock market collapse, the federal agency that insures the retirement funds of 44 million Americans departed from its conservative investment strategy and decided to put much of its $64 billion insurance fund into stocks. Switching from a heavy reliance on bonds, the Pension Benefit Guaranty Corporation decided to pour billions of dollars into speculative investments such as stocks in emerging foreign markets, real estate, and private equity funds."

Be careful if you ever hear these words, "We're from the government. We're here to help you retire."

Run.

If the government can't manage pension funds, how do you think it's going to handle managing a company a complex, bankrupt industrial/financial enterprise GM? Granted, GM's deposed CEO Rick Wagoner is a model of incompetence. But is Barack Obama going to much better? Have you taken a look at HIS business plan for America? You know...the one that ends up with over $10 trillion in debt over the next ten years?

At first Obama's rhetoric was disarmingly pleasant and most vacuous. Change. Hope. A better tomorrow. Who is against those things? Who is for a worse tomorrow?

But behind the million dollar smile is a mind of malice toward free markets. WE are entering the age of command capitalism where the government becomes the lender (not real capital when you're borrowing Chinese money, but let's not quibble) and manager of last resort. The audacity of the command economy is that the folks in the White House can run GM better than the folks in Detroit. Truth be told, neither has been doing very well, which doesn't bode well for the country.

But if Australia is facing the consolidation of the mining sector as the number of cashed up capitalist and willing bankers dwindles, than Washington is witness to a consolidation of failed and failing institutions. Bear Stearns, GM, and who knows who is next are gradually swallowed up by the biggest and most wobbly institution of all, the Federal Government of the United States and its paper thin dollar.

Having said all that, the dollar rallied yesterday against foreign currencies and commodities. Oil was down. Gold was down. The greenback was up. How can that be?

We turn to the report we mentioned yesterday from the Economist (Manning the Barricades). The economist warns that repeated cycles of competitive currency devaluations could keep the U.S. dollar stronger for longer than most of us dollar bears expect.

"While devaluation does not rescue countries from weak global demand, it does provide help at the margin, as well as alleviating deflationary pressures. Consequently, under our main risk scenario, governments are happy to see their currencies devalue provided it does not have adverse consequences for solvency of borrowers."

"This results in repeated cycles of competitive devaluations. There are periodic calls for co-ordinated action to stabilise foreign-exchange markets, although agreements prove elusive. Under this scenario, the U.S. dollar proves stronger than U.S. policy makers would like, as investors continue to view the U.S. currency as a safe-haven of sorts."

There are lots of global players like the Chinese and Russians who clearly do not view the dollar as a safe haven at the moment. But at the moment, they don't have much to choose from. So perhaps the Economist is right. Competitive devaluations will continue, making the dollar a winner by default.

This means that the whole project of ruining the dollar is going to require even more effort by Obama and his sidekick Tim Geithner. And as Edward Chancellor points out in today's Financial Times, until bank lending rises to match the expansion in the global monetary base, inflation will not pass into the real economy.

"Monetarists concede," Chancellor writes, "that central banks are printing money in vast amounts to stimulate their economies. This will not lead to inflation, they say. The newly minted cash is not being lent out but stored in bank vaults.

"The 'money multiplier', to use the technical term, has collapsed. It is no secret why this is happening. Households and businesses are over-stretched and fearful about the future. As a result, they are borrowing less and saving more. As long as such fears persist, according to monetarist logic, the Federal Reserve can carry on printing money with impunity."

But there must be a penalty for such a rash expansion of paper money. The Economist explored that too in its dollar doomsday scenario. More on that tomorrow.

Dan Denning
for The Daily Reckoning Australia

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Last Wednesday, a bunch of peeved mortgagees protesting government favoritism in the Bear Stearns case entered the lobby of the company’s (soon-to-be-former) headquarters building in midtown Manhattan. While it might not seem like much, I view the symbolic “penetration” of this corporate stronghold as the very first sign of a much broader citizen revolt against the extraordinary protections being shown to crapped-out investment banker boyz – at the expense of millions of equally crapped-out poor shlubs facing the default and re-po of their McDwelling places.

Occupying an office-building lobby peacefully in broad daylight is one thing. Wait until summer gets underway and The New York Post gossip page resumes its coverage of hijinks in the Hamptons. The executives of Goldman Sachs, J.P. Morgan / Chase, and other dealers in fraudulent securities, plus the art world and show biz glitteratti who party together out there, might all find themselves the object of considerable grievance and resentment as the beaching season ramps up, and the limos roll around the charity lobster roasts, and the guests stray down the lawns, chardonnays in hand, to plot divorce from their over-leveraged husbands.... God knows what seekers-of-vengeance will be creepy-crawling the privet plantings along Gin Lane in the crepuscular gloom, searching for trophy wives to garrote.

Perhaps a bankrupt landscaping contractor from Lake Ronkonkoma, recently stiffed by a hedge fund manager over the installation of a half acre of pachysandra, will be arrested on the Wantagh Highway with blood on his sleeves and a high-C piano wire in his pocket. The non-Hampton precincts of Long Island, which make up more than 90 percent of the fish-shaped appendage to New York State, will be full of angry repo victims, and the Hamptons lie at the very dead-end tail of the geographical fish. Will the banker boyz attempt to flee by yacht? And where might they escape to? Newport, Rhode Island? Labrador?

I maintain, of course, that the media (and the public itself) has no idea how quickly things might get weird in this country – or how weird they might get.

Now bear with me while I shift gears. [Recently,] I went to a pretty major environmental conference put on by the Aspen Institute in their odd little mountain town – and nobody needs to tell me how un-correct it was that I flew all the way out to Denver and then drove a rent-a-car the size of a humpback whale deep into the heart of the Rocky Mountains to attend this thing. (I assure you, I wasn’t paid to go.) The Institute grounds – which looked like the set of a 1950s Raymond Massey movie about the future – were thick with many eminentissimos of Climate Change (minus Al Gore) and activists in “green” politics, more generally. The latest frightful measurements of retreating glaciers, vanishing species, and creeping deserts were proffered and everybody was suitably impressed by the acceleration of scary conditions facing the human race.

Being such a formal conference, though, with the putative mission to advance understanding and set agendas-for-action, a great effort was made through the medium of panel discussions to set forth various “initiatives” to deal with all the scariness, especially by enlisting the agencies of the U.S. government – and most especially with the prospect of a new administration sweeping out the detritus of Bush-dom next January.

I confess I found most of these well-intentioned proposals utterly implausible, along with their trains of hopes, wishes, and fantasies. The main conceit is that we can keep all the normal operations of the American Dream humming by some “non-carbon” related energy source – in other words, run Wal-Mart without oil, methane gas, or coal – and that all the forces of government and capital can be marshaled to make that happen. The secondary conceit is that they would accomplish these things in an orderly process, harnessing “new technology,” as though it were a higher sort of school science fair.

My own opinion is that these birds have the scale issue wrong. The exigencies of the Long Emergency imply that virtually everything organized at the grand scale will tend to wobble and fail as the problems of energy scarcity and climate change converge. Institutions from the federal government to Wal-Mart to the University of Arizona will face increasing impotence, incompetence, and bankruptcy. Vesting our hopes in propping up activities run at that scale is bound to be disappointing, to say the least, and the precursor to social upheaval to go a bit further. There’s probably a lot we can do at the finer and more modest scale, but that is not the scale that conferences like this focus on – in particular because so many of the participants are current or former high-up government wonks themselves. Anyway, the scale of global distress tends, by plain inference, to invoke the wish for global “solutions,” however detached from reality they may be.

At the center of all this conferencing was the movement’s lead eco-guru, Amory Lovins of the Rocky Mountain Institute (RMI), located just up Highway 82 from Aspen. Lovins’s long-running emblematic project with that outfit is something they call the “hyper-car,” a car that gets such supernaturally great mileage that it will save the human race’s threatened Happy Motoring program from extinction. The hyper-car program, which RMI still trumpets to this day, has, of course, the unintended consequence of promoting future car dependency – which is about the last thing that America needs – but that hasn’t prevented RMI from pushing it. Beyond that, Lovins’s RMI program-for-America resembles an actuarial exercise in “carbon credits” and other statistics-based fantasies aimed at inducing theoretically rational behavior among the Wal-Mart executives (and “greening” up Wal-Mart has been another of RMI’s consulting projects – I’m not kidding).

Here lies my third dissent from what I heard at the conference: since America is bankrupting itself so comprehensively at every level, the wished-for “funding” for the green rescue program will not be there in any case. Capital, as represented by Wall Street, is itself flying to pieces this year as its stock-in-trade of paper certificates loses legitimacy in the face of the overwhelming fact that the society behind that paper will be decreasingly capable of producing surplus wealth – which is what capital is. The unwind of “positions” now underway among the big bankz is the process of previously anticipated capital accumulation vanishing down a black hole. It will be gone forever.

This is the year we find that out. Bear Stearns was not the only sick puppy in the kennel. When another one wobbles and crashes, will the Federal Reserve step in again and accept its worthless CDO paper as collateral on another $30 billion loan, and another, and another, and so on? And will the individual mortgage default homeowner shlubs just watch all this go down on CNBC without any action beyond “penetrating” the lobby of a Manhattan skyscraper? I don’t think so. What goes down in the Hamptons will go down in Aspen, too.

Regards,

James Howard Kunstler
for The Daily Reckoning Australia

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You will recognize that line, dear reader. It describes what happened to Julius Caesar after he was stabbed to death by a group of rivals on the Ides of March in the year

The Ides of March came this past Saturday. When it had gone, the bloody corpse on the ground was that of one of Wall Street's biggest players - Bear Stearns.

Last week, we reported a rumour. That a large Wall Street firm was in trouble - which was said to be the real reason that the Fed announced its new $200 billion of loans.

By week's end the news was out: the Bear had gotten the 'Margin Call from Hell.'

The Fed and J.P. Morgan Chase rushed in to give aid and comfort. But officials were very worried that if a deal to rescue Bear Stearns were not completed before Asian markets opened this morning, there could be a financial meltdown.

"I've been on the phone for a couple of days straight, throughout the weekend," said U.S. Treasury Secretary Hank Paulson on television..."but I'm not going to project right now what the outcome of that situation is..."

"That situation" of course, was the situation at Bear Stearns. Early reports here in London say that a deal was finally struck with J.P. Morgan Chase to buy out the Bear for a reported $2 a share.

The background for this latest crisis is what we've been reckoning within these Daily Reckonings for so many months. The geniuses at Bear Stearns had their calculators...their Black Sholes Option Pricing Model...their mathematicians...their risk figures... They had some of the finest minds in the country - or at least, some of the finest minds money could buy on Wall Street.

And yet, a year ago they also had a stock trading for $150. Now, it is down to $2...the shareholders have been largely wiped out.

When Wall Street got the news of the Bear's predicament, stocks were sold off - driving the Dow down 300 points. Then came word that the Fed and JP Morgan Chase were on the case, and the index bounced back, closing down 194 points. Hardest hit, (this will come as no surprise) was Bearn Stearns itself - down 47%. Other financial stocks took a beating too.

We began last week worrying that we might be wrong. We begin this one worrying that we are probably right. At the beginning of the week, U.S. stocks seemed to be rising more than gold. By week's end, things were happening as they should: God was in his heaven. The queen was on her throne. Gold was rising...and stocks were going down. All is right with the world...or as right as it can be after a 27-year credit expansion.

Little noticed in the Bear affair is the role of Chinese investment firm, Citic. The Chinese were going to put up some money to prop up Bear Stearns. There might be many explanations for why the Citic deal didn't go forward, but here we suggest one that is the most far-reaching: the foreigners are growing wary of the United States. You will recall our friend in Geneva told us to "Sell the United States...sell its money...sell its stocks...sell its debt." That attitude is spreading - the belief that the United States is a short sale.

"For years," begins a report in the Wall Street Journal, "the US economy has been borrowing from cash-rich lenders from Asia to the Middle East. American firms and households have enjoyed readily available credit at easy terms, even for risky bets. No longer."

"Clearly, the whole world is focused on the financial crisis and the US is really the epicentre of the tension," the paper quotes Carlos Asills, at Globista Investments. "As a result, we're seeing the capital flow out of the US."

Ed Hadas adds:

"The Fed's rescue of Bear increases the odds of a generalized, taxpayer-funded financial bailout. Combined with super low rates, that will add to pressure on the beleaguered dollar. Bear is the biggest firm so far to hit the wall this time around. But the biggest name in financial distress could eventually be the US."

*** How do you like those foreigners? We were nice enough to take their money...spend it on stuff they sent over...and ruin our own economy and our own balance sheets so theirs could grow at breakneck speed. And this is the thanks we get! Now that we really need their money, instead of opening their wallets, they ask questions: what's that paper really worth, they want to know?

The United States emits a lot of paper - bonds, notes, SIVs, MBS, securities, repos, you name it - but one piece of paper is the one emitted most and the one the foreigners are probably most concerned about: the paper with pictures of dead presidents.

Colleague Manraaj Singh in London surveys the latest ungrateful grumbling:

"In Japan, Finance Minister Fukushiro Nukaga, today said abrupt currency moves are 'bad' for economic growth, while Economics Minister Hiroko Ota called them 'undesirable' and blamed them on dollar's weakness rather than yen's strength - those are strong statements from the normally reserved Japanese. Closer to home, European Central Bank President Jean Claude Trichet said on Monday that he [was] still concerned about the impact of the euro's surge.

"In Brazil, they've already gone beyond talking about it though. They've taken action to stem the currency's appreciation by reducing the flow of hot money into the country. Brazil has introduced a 1.5 per cent tax on purchases of real-denominated, fixed-income securities by foreign investors and will no longer require exporters to pay a 0.38 percent levy on currency purchases in order to cut the costs of sales abroad.

"'The [US] dollar is melting,' Brazil's finance minister Guido Mantega, said on Tuesday. 'Our plan is to avert an abrupt impact on the foreign exchange rate and help mitigate, in a smooth way, the dollar's freefall.'"

The Wall Street Journal fears a "rout" in the dollar this week. "Dollar poised to fall again," it says...pointing out that another rate cut is likely to send investors rushing to other currencies. It's hard for us to believe that investors don't already know about the coming rate cut and haven't already sold off the buck.

It seems more likely to us that world's central bankers will announce an effort to save the greenback - which will send the dollar up again. If that happens, dear reader, you know what to do: sell it on the bounce.

Bill Bonner
The Daily Reckoning Australia

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